Real Yields and the Market

Studying history promises no shortcut to easy profits, but it does provide some intriguing perspective at times. The last six months or so is one of those times. We're speaking here of the real or inflation-adjusted rate on the 10-year Treasury yield. By our somewhat subjective calculation (more about that below), this real yield has gone negative in recent months, which is to say that owning a 10-year Treasury bond leaves owners with less than nothing after deducting inflation.

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The negative real yield in the 10-year isn't unprecedented, although as the chart above reminds it's a fairly rare occurrence. Back in 2005, the real yield went negative in September, but that was a one-time flirtation with life below zero. The last sustained dive into negative territory came during a two-year stretch in 1978-1980. Of course, that was a time when inflation was taking a toll on fixed-rate investments and the country was grappling with high energy prices. (Sound familiar?)

There are three paths to negative real yields. The first is higher inflation. The second, falling yields. Three, a combination of the previous two. We seem to have arrived at the current state of negative yields via the combo deal.

Deciding what it all means remains speculative, but here's what we do know. The 10-year yield went negative last November for the first time since 2005; the yield then rose to zero in December 2005 and has since slipped back into negative territory ever since. As of last month, the 10-year yield is a slightly negative 0.22%.

Of course, there's more than one way to calculate real yields. For good or bad, our methodology here is taking the constant monthly 10-year Treasury yield (as per the St. Louis Fed's database) and adjusting it by the 12-month change in consumer prices, as per the CPI index. The result is the graph above. For example, the constant 10-year Treasury yield was 3.68% in April 2008, according to St. Louis Fed. Meanwhile, the 12-month change in CPI through April 2008 was 3.9%. Thus, the slightly negative 10-year yield (3.68 less 3.90 = -0.22).

What does that mean? For starters, one might think twice before locking in a negative interest rate for the next 10 years. True, there aren't a lot of good alternatives at the moment, but that's a story for another day. Unless you're expecting deflation, negative yields are about as appealing as open flames at a gasoline station.

Then again, based on the past 54 years, negative real yields don't last long, which suggests a case for waiting for better valuations. The 1978-80 bout was the longest stretch of negativity, at 26 months, albeit interrupted by one month of slightly positive yields. The longest uninterrupted run was 24 months between 1973 and 1975.

You'll note that in both of those periods inflation was a problem and there was more than a trivial amount of pain in the capital markets and economy. By contrast, today's struggle with inflation is a mild affair and the capital markets and the economy are only slightly bruised by comparison with 1973-1975 and 1978-1980. That's no guarantee that deeper ills don't await, but for the moment 2008 is faring surprisingly well given the record high prices in oil and gasoline.

For what it's worth, we expect something between the apocalypse and nirvana as the path of least resistance. Of course, that's always the default forecast, and now's no time to look for extremes, which is our way of saying that we're as clueless as anyone about what's coming. As such, we're optimistically cautious, or cautiously optimistic, if you prefer. Then again, that outlook is conditioned on expecting that the global markets portfolio will fare reasonably well in the years ahead. Yes, there are a number of risks still looming, which suggests to your editor that broad diversification across equities, bonds, REITs and commodities is still the best game in town.

There is no doubt that some will do materially better with their portfolios. What worries us is that many will do materially worse.

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